CHAPTER SEVEN

CAPITAL BUDGETING
Capital budgeting or capital expenditure budget is a process of making decisions regarding
investments in fixed assets such as land, building, machinery or furniture. The word
investment refers to the expenditure which is required to be made in connection with the
acquisition and the development of long-term facilities including fixed assets. It refers to
process by which management selects those investment proposals which are worthwhile for
investing available funds. For this purpose, management is to decide whether or not to
acquire, or add to or replace fixed assets in the light of overall objectives of the organization.

7.1. Capital Improvements Program (CI

A capital improvements program is a blueprint for planning a community's capital projects. A

CIP is a multiyear planning instrument used by governments to identify needed capital
projects (the maintenance, repair and rehabilitation of existing infrastructure as well as the
construction of buildings, utility systems, roadways, bridges, parks, landfills and heavy
equipment which have a high cost and a useful life of several years); the project
appropriations or spending that must be incurred to make those needs a reality; the sources of
financing for the projects; and the impact of the projects on future operating budgets. A CIP
is not a static document. It should be reviewed every year to reflect changing priorities,
unexpected events and opportunities.

Purpose of Capital Improvements Program (CIP)

A. Mechanism for formal decision making

A CIP provides government with a process for the planning and budgeting of capital needs. A
CIP answers such questions as what to buy, build, or repair and when to buy or build. It is a
useful tool for prioritizing of capital projects.

B. A link to long range plans

A CIP serves as a link to the planning process and should be developed with the land use
plan, strategic plan and other long-range plans. When determining whether or not new
infrastructure should be constructed or existing infrastructure should be replaced, it is
important to consider changing demographics and land use patterns.

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 C. Financial management tool

A CIP is used to prioritize current and future needs to fit within the anticipated level of
financial resources. When looking at capital projects, it is important to consider the operating
and maintenance costs that will be incurred with the construction or replacement of
infrastructure. A CIP will allow for better financial planning and will smooth the need for
sharp increases in tax rates or user fees to cover unexpected repairs, replacements or
construction of capital assets.

D. Reporting document

A CIP presents a description of proposed projects that will be undertaken over the planning
period. The CIP is used to communicate to citizens the government unit’s capital priorities
and plans for implementing projects. It also includes the expected source of funding for
projects.

7.2 Capital Budget

Capital Budget is also known as "Investment Decision Making or Capital Expenditure

Decisions" or "Planning Capital Expenditure" etc. Normally such decisions where investment
of money and expected benefits arising there from are spread over more than one year, it
includes both raising of long-term funds as well as their utilization.

Capital budgets in governments have multiple roles: as instrument of fiscal policy and to
improve the net worth of government, and particularly in the area of economic infrastructure
as vehicles for economic development. Governments have introduced capital budgets to serve
all these objectives, singly or collectively, depending on the context.

Budgeting for capital items is most often associated with longevity, high cost, and major
impact. Items that have a useful life extending beyond a single year are considered to have
longevity and are candidates for capital budgeting. Such items become fixed assets. Also,
high-cost physical items that make a substantial impact on an annual budget if funded in
anyone year are candidates for capital budgeting. Finally, items expected to have a
significant impact that are not easily changed are often included within a capital budget.
Examples of capital items are land, public buildings, large and expensive equipment, and
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public improvements, such as streets and sewer, are all items that should be included in a
capital budget.

Capital budgeting is the process of identifying and selecting investments in long-lived assets,
or assets expected to produce benefits over more than one year. Moreover, capital budgeting
is concerned with the firm's formal process for the acquisition and investment of capital. Due
to these concepts, capital budgeting is important because of the following reasons:

 Capital budgeting decisions involve long-term implication for the firm.

 Capital budgeting involves commitment of large amount of funds.
 Capital decisions are required to assessment of future events which are uncertain.
 In most cases, capital budgeting decisions are irreversible. This is because it is very
difficult to find a market for the capital goods. The only alternative available is to
scrap the asset, and incur heavy loss.
 Capital budgeting ensures the selection of right source of finance at the right time.
 Wrong sale forecast; may lead to over or under investment of resources.

7.2.1. Elements of Capital Budgeting

Three major elements exist within a capita1 budget process: (1) planning, (2) cost analysis
and (3) financing. Each requires a certain amount of research capability, staffing (either
external or internal), organizational capacity, and expertise.  

1. Planning

Effective capital budgeting requires a comprehensive planning effort. This effort includes a
number of elements: (1) an inventory of existing capital assets, (2) a review of constituent
demands for goods and services in the future, and (3) a review of replacement needs of
existing capital assets.

Surprisingly, most public and nonprofit agencies lack a comprehensive inventory of their
capital assets. Depending on the size and holdings of the public agency, such a list can be
relatively easy to produce or can represent an enormous undertaking. Such an inventory can
include some of the following elements: the type of facility or equipment asset; the date the
asset was acquired; the initial cost of the asset; any improvements that have been made; the

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existing condition of the asset; the level of utilization of that land, facility, or equipment; its
depreciated value; replacement cost; and the anticipated end of its useful life or replacement
date. This inventory can be used as the first step in a risk management program as well as a
capital budgeting program. 

Perhaps one of the most difficult parts of a capital budget planning effort is, to develop a
clearly defined needs analysis to help the organization determine future demands for capital
assets. Information on current and future needs guides where public resources should be
directed in acquiring capital asset. Such analysis requires the incorporation of existing
replacement needs, a review of shifting external changes, and any anticipated internal
changes that affect the need or demand for such capital assets. 

An analysis is used most commonly for major capital improvement projects such as
buildings, streets, sewers, and large equipment. In some cases, the approach is similar to the
environmental scan elements of strategic planning. The agency should consider factors, both
internally and externally, that affect the need associated with capital acquisition. Several
factors are incorporated into such analysis. Shifts in population size and location provide
indications of where new facilities may be required. This is very common with public school
systems, where changes in the number of elementary school children and corresponding
changes in the number of high school students may require acquiring some new buildings and
closing others. Changes in facility use can also occur.  

Demographic and cultural changes of the existing constituent base and changes in legal
requirements can portend increasing demands for services. Changes in federal and state laws
affecting health care benefits for the poor and elderly have increased demands for facilities
and services, particularly at the state level. 

Planning includes a systematic review of the replacement needs of existing facilities and
equipment. Most facilities and equipment have an expected useful life span, which may range
from a few years to as many as 40 years. Replacement periods can be based on both wear and
tear and usage or on technological obsolescence. Streets, sewers, and front-end loaders are
examples of the former, whereas computers, telecommunications equipment, and other
electronics equipment exemplify the latter. 

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Technological obsolescence does not mean that facilities or equipment do not work or require
increased maintenance. It simply means that more recent advances in technology have made
the facilities or equipment less useful than new facilities or equipment to meet current and
future demands. This is a very different situation from one in which equipment, because of
wear and tear, has increasing downtime when it is unavailable or where the maintenance and
replacement part costs begin to exceed the actual depreciated value of the equipment itself.
Streets that are constantly under repair or buildings with major structural and mechanical
problems are recommended strongly as candidates for replacement. 

Replacement schedules should be developed when facilities and equipment are acquired. This
allows a public agency to plan years in advance of the actual need for the replacement. This
information can also be placed on a capital budgeting calendar so that replacement decisions
can be contrasted with decisions for acquisition of new capital assets. 

These replacement schedules should be based on useful life, with a clear understanding of the
trade-offs between replacement relative to repair or maintenance and between replacement
and modernization. Replacement schedules-which are forecasts, after all-should be adjusted
yearly to account for factors that have changed since that schedule was developed. For
example, street replacement may be based on assumptions about level of usage. If the usage
or wear and tear is greater than originally thought, the replacement schedule should be
adjusted to reflect such a change. 

2. Cost analysis- Evaluating Expenditure Decisions

Perhaps the most difficult decision faced by policymakers and administrators is choosing
which capital assets to acquire or replace. Most public organizations have limited resources
and face legal as well as political restrictions on their ability to raise revenue. For these
reasons, a limited number of capital items can be acquired during any one time period.
Priorities must be set to fund those that are considered the most important. Importance can be
determined by some form of economic analysis or by other concerns (political need, fairness,
or visibility). Assuming, however, that some form of systematic analysis is useful, most
finance professionals suggest using a systematic method to evaluate the importance of
various capital acquisitions. These methods involve numerous criteria-quantitative,
qualitative, and political. The key is to match available revenue sources with a wide-ranging
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set of expenditure options and to match expenditure options to revenue availability. Criteria
can be developed that are simple or complex. Among the most common are the following.

 Costs of any particular project, facility, or equipment relative to competing projects,

facilities, or equipment
 Costs relative to benefits for competing projects, facilities, or equipment
 Relationship of the capital asset to the specific goals and objectives of the
organization.
 Financial impact of the project on defined beneficiaries
 Capital costs relative to operating and maintenance costs
 Spin-off benefits of the capital asset to other public and private activities
 Effect on improved efficiency of organizational activities
 Political costs and benefits of the project
 Legal mandate of a project or activity mandated by law
 Chances for external funding
 Relationship to future needs and demands

Although this list is not exhaustive, it does provide a wide range of criteria to consider when
developing an evaluation system. The major focus is deciding which capital assets to fund
lies in the area of cost.  

Cost-effectiveness and cost-benefit analysis can be used to compare capital expenditure

items. Not all capital expenditures are associated with their cost relative to their benefits;
however, many decisions are made on other bases. Other decisions are made on the grounds
of equity rather than cost. Providing mass transit facilities in low use areas may make little
economic sense. If these areas are also populated by low-income citizens, however,
eliminating such facilities simply because they are not economical is often rejected by public
agencies responsible for such facilities on the basis of equity. 

Another example pertains to disabled access to public facilities. Retrofitting public buildings
or transportation equipment and facilities to allow for disabled access is not the most cost-
effective way to ensure particular outcomes; however, it does serve social and political
objectives or meet legal requirements that make such expenditures necessary.  

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There are many different ways to evaluate capital expenditures. Various factors can be
weighted in level of importance and then ranked according to a quantitative system. Opinion
surveys can be used along with qualitative analysis to determine level of support for various
projects. This is especially helpful if a project or facility is potentially controversial among
elected officials or citizens affected. 

3. Financing

No matter how various projects are ranked, rated, or prioritized, the funding of capital items
is contingent on adequate revenue. Revenue sources should suffice to encompass both the
capital expenditure and the operating or maintenance costs associated with that expenditure.
It makes little sense to purchase a piece of equipment if an organization cannot afford to
maintain or repair it. 

Two major modes of financing capital projects are pay-as-you-go and pay-as-you-use. The
most conservative financing approach is pay-as-you-go. This simply means that the
expenditure of0 funds for a capital item does not occur until the money is in hand. Debt is not
incurred to fund all or a part of the capital item. On the other hand, pay-as-you-use
proponents argue that financing should occur as the capital asset is used. Incurring debt to
fund such an item is logical because the debt can be paid throughout the item's useful life. 

Both approaches may be appropriate, depending on the particular situation facing the
organization. Both have inherent strengths and weaknesses. Pay-as-you-go ensures that an
organization does not borrow money to finance capital assets. Interest charges are a measure
of opportunity cost. Public organizations must choose between more expenditure to have
more capital facilities and equipment, which means more revenues, and less expenditure,
fewer capital items, and fewer revenues. Unfortunately, fewer expenditures and revenues and
more capital items is not possible. If concern exists about borrowing money and incurring
debt to obtain capital facilities, the pay-as-you-go approach may be the more acceptable
action. 

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The disadvantage of pay-as-you-go can be substantial. Many capital items would never be
acquired or replaced because funding is simply not available within existing resources of an
organization. In this sense, pay-as-you-go discriminates against larger expenditures. In small
organizations or where the capital item is expensive, the pay-as-you-go approach can create
much greater fluctuations in the budget expenditures from year to year and can also create
fluctuations in the revenue load of the organization's supporters. This is not a particular
problem for the national government, which has such an enormous budget that anyone capital
expenditure is unlikely to have a substantial impact.

In a small town, however, building a new fire station or paving a street can have a substantial
impact. In addition, the concept of intergenerational equity is violated with a Pay-as-you-go
approach. This means that those who benefit from the item are not necessarily the ones who
finance the asset. For example, if taxpayers in a community use money that had been saved
over a period of years to build a recreational center, the beneficiaries of the center may not be
the same as those who put their tax dollars toward building it. Some may move away or die.
Then, they will have helped pay for a facility that they never have a chance to use. This is
considered inequitable.

Pay-as-you-use financing is beneficial for a number of reasons. First, it helps spread the costs
of the capital asset over a number of years, thus making acquisition or more feasible in many
cases. It avoids great fluctuations in expenditures and revenues. Second, it provides for
intergenerational equity by allowing those paying taxes or user fees for a particular capital
expenditure to have access to that item. 

There are dangers associated with the pay-as-you-use approach. The greatest concern is that
financing of capital items might exceed the useful life of that asset. In other words, a public
agency should not finance a piece of equipment for 10 years if it is likely that the equipment
will need to be replaced in 5 years. Such borrowing can place the agency in a financially
precarious situation, where it is using current revenues to pay for capital assets that no longer
exist.

 Several options exist for public agencies that do not wish to rely exclusively on either pay-
as-you-go or pay-as-you-use. One approach would be to use a substantial down payment for a
capital expenditure and to finance the remainder through borrowing. In this way the amount
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financed through debt can be reduced, yet intergenerational equity can be partially protected.
A similar approach is to shorten the maturity date of the debt that is issued to finance capital
acquisition so that debt costs are minimized and items are funded before the end of their
useful lives. 

Another option is to set up a sinking fund that can cover costs associated with replacing a
capital item. Money is put into the fund yearly. This is similar to debt in extended funding
and is used extensively in replacing equipment and other short- or intermediate-lived capital
items. The money can be invested in interest-bearing accounts, and the principal and interest
can accumulate at the rate such that at the time a capital asset must be replaced, funding
necessary to pay for that replacement is readily available. It is extremely important that when
such funds are created, they are maintained separate and distinct from other funds. It is often
tempting to raid these funds to help cover the costs of other operating items within the budget
or to deal with other concerns, such as revenue shortfalls. 

Under certain circumstances, leasing provides an attractive alternative to either financing

approach. This is a variant of pay-as-you-use, because ownership is not involved. When a
capital asset is likely to have a very short useful life, as is the case with certain kinds of
equipment (automobiles and computers and so forth), or whether the financing costs (both for
incurring debt and for servicing and maintenance) will be clearly lower, leasing is an
alternative to acquisition. In many instances, a public agency can obtain title to the capital
asset at the end of a lease at a minimal cost. The disadvantage to this, however, is that the
asset may have reached the end of its useful life at the end of this period. 

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